An investor’s perspective on Turkey’s coup attempt

25-08-2016 | Emerging markets alert

After the recent coup attempt, President Recep Tayyip Erdogan has strengthened his grip on the country. In our view, current developments do not bode well for Turkey’s political and economic future, causing us to reduce our holdings in this country to an underweight position.

Dimitri

Chatzoudis

Executive Director, Portfolio Manager

Speed read

Erdogan expected to push even more for higher GDP growth

Economic imbalances will increase, making the country vulnerable

We have lowered our Turkish position to underweight

A military force tried but failed to overthrow the government of President Recep Tayyip Erdogan on Friday 15 July, leaving an estimated 300 people dead and 2,100 injured. Once the coup fizzled out, the Turkish government reasserted itself and arrested over 6,000 alleged plotters. It was the sixth coup or coup attempt in Turkey since 1960.

In order to understand the recent developments and its investment implications, one needs to understand the role of the army in Turkey and how this changed when Erdogan came to power. We will look into these issues first, before discussing the consequences of the recent events.

The role of the army in Turkish society

Mustafa Kemal, better known as Atatürk (Father of the Turks), is perceived in Turkey as the man who founded modern Turkey. After the first World War, the allied forces occupied Turkey. Atatürk, who had been a military officer during the war, led the Turkish National Movement in the independence war against the Allies. After defeating the foreign powers, Atatürk became the first President of Turkey. He implemented a program of political, economic, and cultural reforms, seeking to transform the former Ottoman Empire into a modern and secular country.

Under Atatürk’s leadership, thousands of new schools were built, primary education was made free and compulsory, and women were given equal civil and political rights. Besides that, he also changed the role of religion. Religion was seen by Atatürk as one of the main obstacles to modernization and therefore state and religion were separated and religious leaders lost their power. The fact that Atatürk was a man of the army gave the army an enormous amount of authority. After Atatürk’s death the army perceived itself as being the guardian of the secular state and democracy. In the name of this new role the military repeatedly intervened over the years to keep Turkish democracy on what it thought was the right course in times of instability. The army stood basically above the law and for years was the ultimate power.

Erdogan comes to power at the expense of the military

Born into a working-class family on Turkey’s Black Sea coast, Erdogan moved to Istanbul at age 13, where he joined the youth wing of a party founded by Necmettin Erbakan, architect of Turkey’s political Islamic movement. Erbakan called for the strengthening of Islamic values in Turkey and moving away of the Western world in favor of closer relations to Muslim countries. In 1997, the military forced Erbakan to step down as prime minister of Turkey.

Erdogan’s political career took off when he was elected mayor of Istanbul in 1994. Erdogan is both a pragmatic and religious man. His religious side got him in trouble in 1997 when he was sentenced to 10 months in jail for reading a poem from an Islamist poet during a demonstration. His pragmatic side showed in 2001, when Erdogan founded the AKP (Justice and Development Party). The AKP did not center its image around an Islamic identity. Its leaders underscored that it was not an Islamist party and emphasized that its focus was democratization, not the politicization of religion. In 2003 the AKP won the elections and Erdogan became the prime minister of Turkey.

‘Erdogan more likely to succeed in installing a presidential system’

In the first years Erdogan got support from Fethullah Gülen and his Gülen movement. In 2013 there was a political conflict between the two leaders which led to a separation. The Gülen movement has been characterized as a modern blend of Islam. It tries to combine the beliefs of Atatürk’s secular republic with a traditional but flexible Islamic faith. Gülen has been on a self-imposed exile in the US since 1999, as he feared that he would be tried for his Islamist opinions. It is unclear how many people support his movement and estimates range from a couple of hundred thousand up to 7 million. The Gülen Movement has long been accused of maintaining influence in the Turkish political and legal systems and trying to build a ‘parallel state’.

In 2010 the AKP held a constitutional referendum on a number of changes to the constitution. The changes were aimed at bringing the constitution into compliance with European Union standards. One of the amendments in the Constitution was to abolish the protection of military leaders. The amendment allowed the leaders of coups to be sent to court and military officers who committed crimes against the state, such as preparing coup plans, would be tried in civilian courts. The majority of the population supported the constitutional amendments and the army lost an important part of its powers.

This was a critical development for the country and the start of a new era. No longer could the army intervene whenever it wanted without potentially being punished. It also gave room to Erdogan to further consolidate his power without the risk of being thrown out of office by the army. In 2014, after three terms as prime minister - the limit, under party rules - he was elected president. A change that signaled a shift in power in the Turkish government. Though presidents had been selected by parliament, the function was more symbolic and represented held little real power in the past. Erdogan however quickly showed signs that he intended to play a larger role than past presidents had. It became clear that it was Erdogan’s goal to move away from the current parliamentary system with limited powers of the president to a presidential system where the president had executive powers. Erdogan himself would of course be the first president under this new regime. These historic developments put into context the motives that at least part of the armed forces could have to support forces that would be willing to overthrow Erdogan.

Political implications of the recent coup

It is still unclear who the real leaders of the recent coup are. The Turkish government has been pointing to Fethullah Gülen and his Gülen movement. In Turkey it is a widely held belief that the United States want to overthrow Erdogan and that the CIA is to be blamed for the coup. At the same time in the West a lot of people think that this coup was staged by Erdogan himself.

Although we do not know who is behind the coup, we know that it did not succeed and that Erdogan emerged as the main winner. This victory has two important consequences. Firstly it allowed Erdogan do declare the state of emergency for at least three months. This gave him the room to implement a lot of changes that otherwise would have been very difficult to achieve. Roughly 6,000 servicemen have been arrested, among them about 100 higher officers. Nearly 3,000 judges and prosecutors have been sacked. Altogether 60,000 people have been fired for suspected links with the Gülen movement. Besides that, the pressure on all forms of media has increased. All in all the failed coup allowed Erdogan to significantly enhance his grip on the state system and the media.

Secondly, it considerably increased popular support for Erdogan. Erdogan is now being portrayed as the strong man that can defend Turkey against its potential enemies. In fact one could say that the coup and Erdogan’s victory have given Erdogan his ‘Atatürk moment’ in history. With hindsight this might prove to be a moment where Turkey’s political direction fundamentally changed again. Erdogan could use current popular support to change the constitution to the presidential system.

In order to change the constitution in Turkey one needs to either have a two-thirds majority in parliament or it can been done through a referendum. AKP currently does not have a two-thirds majority so it has three options: convince other parties to support the constitutional change, launch new elections or organize a referendum. We have to see which route will be chosen and what the timing will be, but Erdogan currently has a tremendous amount of popular support and, not surprisingly, a lot of support from the media as well. He can make his next move and the probability that he will be successful has increased considerably after the recent events.

Erdogan and the economy

The next question to raise is what the economic implications would be if Erdogan were to become president with executive powers. If we have to characterize Erdogan’s existing economic policy in one sentence, we could say that the policy has been to push for high GDP growth even if this leads to macro-economic imbalances. GDP growth has indeed been relatively high over the last couple of years, but debt levels in the economy have rapidly increased as well. What is even more dangerous is the fast rise in external debt. External debt to GDP stands now at 55%. This is one of the highest in the emerging world; for most emerging countries this ratio is below 40%. This rapid increase in external debt makes Turkey vulnerable. This does not give any significant problems in the current environment of low interest rates and search for yield, but makes the country very vulnerable in case global liquidity were to dry up.

Besides that, Turkey has also run a loose monetary policy. In a world where practically every other country has seen inflation decline, Turkey has seen inflation stay at elevated levels of around 8%. The current account deficit has also consistently stayed at high levels. High domestic growth has translated into a continuous need for imports. The currency has weakened significantly, but the current account deficit is still there. At the same time, over the past couple of years there has been a lack of structural changes that could improve the competitiveness of the economy.

We have also seen this type of policy mix in other countries in the European periphery. It can go on for a number of years, but as we seen happening in other countries, things can go wrong very fast once global liquidity dries up.

Our expectations: erosion of the country’s fundamentals

So what to expect? Our base scenario here is that Erdogan will continue with the same policy mix, but given his increased power, he could become much bolder in executing it. We could expect an increased pressure on banks, for example to lend more money or to lower interest rates. We could also see a stronger push into infrastructure investments, even when these are not always productive. This would certainly not be a new phenomenon in the emerging world.

If Erdogan were to become president with executive powers, we would - in our base case - also expect corruption in Turkey to increase. We have seen numerous times in other emerging markets that corruption levels go up if political parties or leaders stay in power for too long: power corrupts, absolute power can take corruption to far more extreme levels. This would then be negative for competitiveness, Foreign Direct Investment et cetera. These effects will not happen overnight, but they will slowly erode the underlying fundamentals of the country.

But, as we have said before, Erdogan is also a pragmatic man. In the past he has shown to be able to change if things do not work out. This could happen again. It could be that if he sees that the existing economic policies are not working, he will start a new program of reforms, just like he did when the AKP came to power in the previous decade. Although possible, and we have this in the back of our minds as the alternative scenario, we think that the probability of this happening is relatively low. Experience shows that powerful leaders usually prefer to increase the dose of the existing medicine, instead of prescribing a new one.

Our position: a small underweight

Earlier this year we downgraded our stance with regards to the Turkish political situation. As a consequence, we lowered the overweight portfolio position in Turkish equities in our core Emerging Markets strategy. Directly after the coup we reduced our position further. Turkey currently is 1.2% of the MSCI Emerging Markets index and at 0.9% (31-07-2016) Robeco’s mainstream Emerging Equities strategies currently have a small underweight position.

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